Why is the British Pound Sterling (GBP) all over the news? Complex narrative simplified

Why did GBP lose its value?

Government income is primarily tax receipts and expenses are mainly interest expense and services cost (Health Services, Infrastructure etc..).

Tax cuts announced by the UK chancellor will result in much lower tax income. UK will have to borrow more to fund the gap.

The creditors in turn expect higher interest to compensate for the additional risk.

The GBP slide reflects markets verdict on the reduced tax receipts and lower interest rate on offer in UK compared to better economic prospects and higher rates on offer in US.

How did the Bank of England (BoE) intervene?

Although UK’s headline inflation is higher than US, BoE has been measured in interest rate hikes.

It is a delicate balancing act, rapid rise in rates will exacerbate cost of living crisis and tip economy into deep recession.

The UK “mini budget” tax cuts had unintended consequence on pension funds threatening UK’s financial stability.

Emergency interest rate increase would have been sufficient to avert pension fund crisis but would have impacted economy adversely.

BoE chose the best of the bad options. BoE has temporarily committed to buy or fund UK debt to maintain stability.

How did the pension funds threaten financial stability?

LDI (Liability driven investment). At risk of oversimplification, for illustration purpose, assume

1. Pension funds have obligation to deliver 10 bananas to retirees.

2. If the pension fund has 10 bananas, we are all good.

In the recent past, bananas have become expensive due to structural market conditions but the regulation mandates zero funding gap i.e. zero banana gap, so what is the solution?

3. Funds have 5 bananas and 3 apples but they have contract to exchange 3 apples for 5 bananas under certain conditions in the future with the counter party.

4. 5 bananas + 3 apples + contract = 10 bananas. Pension is considered to be fully funded.

5. In theory, it works but in practice, it will only work when the supply of bananas and apples is stable and predictable.

6. If the market becomes illiquid, central granary has the power to replenish apples or bananas in the short term to stabilize fruit market but it cannot control the price in the long run (inflation).

In technical terms, bananas are long dated government bonds, apples are all other assets, contracts are levered derivative exposure and BoE is central granary.

When long dated bond yields jumped 120 basis points in 3 days, it created unstable supply-demand equation.

BoE stepped in to buy long dated government bonds to stabilize yield in the short term but will fuel even higher inflation and higher peak interest rate on a long run.

To be continued...take it easy until next time

Note: Views are personal and certainly not an investment advice. Article is oversimplified for educational purpose.

You can read my writings at view all blogs.